Michaels' IPO Won't Solve All Its Problems

The IPOs just keep on coming. Michaels Stores, yet another privately held company hungry for investor cash, will soon be publicly traded. Unlike many of the Internet-associated firms going public these days, Mike operates a distinctly old-school chain of offline shops. The money it'll make from its public offering will come in handy, but the firm has problems and the fresh dollars won't solve all of them.

Time is on its side
Michaels is riding a pair of trends to the market. There's the IPO thing, of course, with new companies arriving on the market seemingly on a daily basis lately. Also, the nation's affection for scrapbooking looks to be pretty durable. So the timing's doubly good for a listing of a specialty crafts store.

Or triply good. The company has been publicly traded before, but that ended in 2006 when big-time financial players Blackstone Group and Bain Capital took the firm private. That strategy worked, as the company slowly turned profitable starting in 2009. In its most recent fiscal year, Michaels drew revenue of $4.2 billion and netted $176 million. The latter number was 71% higher than in 2010.

Bills to pay and growth to spur
What's limiting Michaels' potential, though, are the investments it'll have to make before it gets in better fighting shape. The most important is debt repayment -- as of this past January, the company owed almost $3.4 billion, and had barely one-tenth of that amount to reduce that load. If the IPO is well subscribed, it will help greatly to whittle that down. The problem is, it'll also prevent the company to some extent from making investments that will help grow the business.

Investors will demand growth, of course, and although the company has brought returns, they haven't been spectacular. Top line increased a lackluster 4% year over year in both fiscal 2011 and 2010. In fact, revenue has crept up only 9% over the past five years -- not quite a runaway success story. Yes, profitability has been vastly improved, but a business can make only so many efficiencies.

And Michaels boasts a limited number of places in which to make them. The company has opened very few new stores over the years. From 2007 to 2011, it added only 69 locations to make a total of 1,198. In percentage terms, that expansion isn't very wide -- only 6%, all told.

The big boys loom
Another problem is the competition looming. Although Michaels, being a specialist, occupies a niche in the craft supply market, many of the wares it sells can be found in big-box retailers and in home furnishing stores. Numerous competitors with greater resources and purchasing power -- like Wal-Mart (NYS: WMT) and Target (NYS: TGT) -- have craft sections in their stores.

And should Michaels start to race ahead in terms of sales and market presence, you can bet those giants will do their best to knock it down. Expect discounts thanks to economies of scale, and expect those sections in their stores to expand. Wal-Mart, for example, has nearly 9,000 outlets and a war chest of over $7 billion, and is less indebted, in percentage terms, than Michaels. Wal-Mart has had its setbacks lately, but it's always a potentially lethal competitor.

Target, meanwhile, has only 765 more stores than Michaels, but they rope in much more revenue. That's no accident -- Target has an appealing mix of products and is particularly good at shifting this to meet customer demand.

Because everything vaguely associated with the initial IPO seems to pop in day one of trading these days, don't be surprised if Michaels trades well over its issue price. Just be prepared for that level to sink once the honeymoon is over.

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At the time thisarticle was published Fool contributor Eric Volkman owns none of the stocks mentioned above. The Motley Fool owns shares of Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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